French Investment in US Real Estate

by Stephen Kass on October 7, 2012

  • Initial inquiry
  • For U.S. tax purposes, the result will depend on whether the entity is deemed to be a partnership or a corporation.
  • Partnership analysis
  • If the entity is a partnership, then rental income and expenses will be effectively connected with a U.S. trade or business, or in any case, the individual partners should make a protective “net basis” election under section 871 (d) of the Internal Revenue Code for such treatment. Thus, there will be no withholding obligations by the U.S. partnership.
  • However, the partnership will be required to compute “estimated” income taxes for each of the foreign partners at the highest individual rate (39.6%), per section 1446 of the IRC, and pre-pay these amounts quarterly with the Internal Revenue Service. These rules differ from normal U.S. partnership rules in that the partnership’s only reporting obligation is to supply the annual Form 1065 K-1’s , which the individual partners use to compute estimates at the end of the year.
  • The individual foreign partners will receive, from the partnership, an annual Form 1065 K-1’s providing the partner’s annual share of the partnership income. The individual partners in the must file Form 1040 NR with the IRS which will include, as income, the amount from the K-1, and as prepayments, the summary provided by the partnership.
  • Furthermore, if the real estate is sold there will be withholding on the sale proceeds by the transferee. Estimated income calculations for the quarter will include the net gain realized on sales of such real estate. However, if the U.S. partnership interest is disposed of in its entirety, before the real estate is sold, then there may be withholding, by the partnership, under the FIRPTA rules provided by section 897 of the Internal Revenue Code.
  • Corporate analysis
  • If the entity is deemed to be a corporation, then the corporation should also “elect” for net basis treatment. The corporation will be taxed up to 35%, which is lower then the maximum individual rate of 39.6%. Furthermore, the only filing obligationwill lie with the corporation, which will file an annual Form 1120F along with quarterly estimates.
    If the property is sold, there will be similar results as with a partnership (10% withholding on proceeds by transfereeexcept that the corporation must also withhold 28% of the net gain.
  • However, the corporation will also be subject to the branch profits tax of 5% of the effectively connected earnings & profits not distributed or reinvested in the U.S. Furthermore, the corporation will have filing obligations under 5472 for transactions with affiliated entities .
  • I. French Taxation
    Under French laws, the entity is a tax transparent entity and is taxed only upon the receipt of income. France taxes residents, generally, on their worldwide income (unlimited liability). The tax rate increases progressively up to a maximum of 56.8%. In addition, there is an added tax CSG (Contribution Sociale Généralisée) of 2.4%. Interest on acquisition loans, and management fees paid by the entity are deductible. If the investment is sold, there is a 4.8% duty on proceeds, except if the entity has floating capital, which will be used in the current deal as structured.
  • Capital gains from real estate located in France are tax exempt if they derive from the sale of the taxpayer’s main residence or from the sale of a qualified second residence. Other capital gains from real estate are taxed as ordinary income, if sold before 2 years. Otherwise, there is a decreasing scale of capital gains tax over 21 years. Gains from the disposal of shares are not taxable if below FF325,800 & above this at a 19.4% rate.
  • Pursuant to the France-U.S.A. treaty , U.S. income tax paid from capital situated in the U.S. is allowed as a credit, limited to the French tax attributable to such income.
  • II. U.S. Taxation
  • A. Will the entity be taxed as a Corporation or a Partnership?
  • An entity is first tested to determine if it is a trust, estate or corporation. It is a partnership, only if it does not satisfy the requirements for one of these entities. While local law(state or foreign country) does not control an organization’s classification, it is pertinent. Also, federal tax rules are applied in light of the legal relationships existing under local law.
  • Pursuant to IRS regulations, there are six major characteristics found in “pure” corporations. These are:
    • Associates.
    • Business objective.
    • Continuity of life.
    • Centralization of Management.
    • Limited liability.
    • Free transferability of interest.
    • An organization is treated as a corporation if its characteristics are such that it more nearly resembles a corporation than a partnership. Thus, the entity must have at least 3 corporate factors, to be taxed as a corporation. However, in practice, organizations incorporated under U.S. law virtually always are treated as corporations. In determining if an entity is a partnership or a corporation the first 2 characteristics are disregarded (Associates & Business objective), and the remaining 4 are analyzed.
    • The IRS has recently issued new “CHECK THE BOX REGULATIONS” that permit the taxpayer to choose the form of U.S. taxation, subject to certain limitations.
    • The entities commonly used in France and their characteristics are as follows:
    • Entity Min Min. Capital Freely Transferable Centralized Mgmt. Tax Category
      Société anonyme (SA) F250,000 Yes Yes Corp.
      Société à responsabilité limiteé (SARL) F50,000 No Yes Corp.
      Société en nom collectif (SNC) N/A No No Partnership
    • B. Partnership Taxation (3 Mechanisms of Taxation)
    • (1) Foreign Partners distributive share of Partnership EC Income Code section 1446(a) imposes an obligation on a domestic or foreign partnership that has Effectively Connected income (hereafter “EC”) for any taxable year to make estimated tax payments for its foreign partners. This quarterly estimate is computed by multiplying each partner’s EC taxable income by the highest individual rate for non-corporate taxpayers.
    • This quarterly payment is made on FORM 8813. An annual reconciliation is required to also be filed on FORM 8804. Individual detail must also be provided to each partner on FORM 8805.
    • (2) Fixed or determinable, annual or periodic income (FDAP)
      (a) Non-Effectively Connected Income (definition and withholding) Generally, nonresident aliens are taxed on all income from sources within the United States. The rate of taxation depends on whether the items are deemed to “Effectively Connected with a U.S. Trade or Business” (EC) or Non- Effectively Connected Income.
    • Examples of Non-Effectively Connected Income include passive items such as interest, dividends, rents, annuities. “Interest” that is otherwise deemed the be non-effectively connected, may be EC income when earned from a real estate entity engaged in a U.S. trade or business. To fall under these rules, the excess funds used to generate the interest must be held to meet the present needs of the business, not its anticipated future needs, and must be generated from the business and retained or invested in that business.
    • A foreign partner is subject to withholding on its distributive share (whether or not distributed) of U.S. source noneffectively connected FDAP and certain other gains or losses. If a partnership withholds on the partner’s percentage of FDAP “gross” proceeds, it is not required to withhold when such proceeds are actually distributed to the partners. Withholding is at a 30% flat rate (this is actually the tax and thus there is no filing obligations). The 30 rate may be reduced by treaty with any country. The France-U.S.A. treaty has a reduced dividend rate, but the U.S. fully taxes income from real property.
    • (b) Benefits of EC Income and Rules for such Treatment
      The advantage for Effectively Connected Income is that the taxpayer can deduct all expenses associated with the income and this can even result in a loss that reduces other Effectively Connected Income. The net income is taxed at the graduated rates under the Tax Code. If however, the items are deemed to be Non-Effectively Connected, then these amounts are taxed at a flat 30% rate with no benefit for the expenses associated with the activity.
      To qualify for this treatment, the taxpayer must meet 2 tests: engaging in a U.S. trade/business and the income/expense must be associated with a trade/business.
    • (c) Election for EC Treatment
      Taxpayers who would otherwise not qualify for trade/business activity, can still elect to have this treatment if they “own” real property. Individual partners can make the election; they are not required to actually “own” the property. This election is effective until revoked. In our case, in order to protect ourselves, the individual partners must make the election.
    • To claim such exemption, the person entitled to the income must file a FORM 4224 with the withholding agent. The withholding agent must attach a duplicate of this form to any FORM 1042S filed for such year. Form 1042S is required for each recipient of FDAP income, whether or not tax is required to be withheld.
    • (3) FIRPTA
      Taxpayers used to avoid paying tax on sales through a number of loopholes. The Foreign Investment in Real Property Tax Act of 1980 changed this in that it subjects foreigners to U.S. tax on their capital gains (but not losses) from the sale or exchange of U.S. real property interests, including interests in certain corporations owning U.S. real estate. In effect, these provisions essentially force Effectively Connected treatment on these sales.
    • A transferee, who acquires U.S. real property from a foreign person, is required to withhold 10% of the amount realized by the transferor. This amount must be paid 20 days after the transfer on FORM 8288.
    • However, if the “transferor” is a partnership, then the partnership must withhold 28%(the individual capital gains rate) of the distributive share of the gain realized on the sale by foreign partners. If the transferor is liable under other provisions of the U.S. Income Tax Code, then the transferor is exempt from further withholding requirements. In our case, we already make estimated prepayments under the 1446 and thus should be exempt from FIRPTA treatment. However, the withholding provisions still apply to the “transferee”.
    • C. U.S. Taxation Summary (Partnerships)
    • FDAP Income(Non EC Income) Foreign Partnership EC Income FIRPTA(Forced EC Treatment)
      Withholding/ Estimated Tax Requirements Flat 30% withholding, with treaty benefit for dividends. Estimates computed- EC taxable income multiplied by highest individual rate (39.6%). 10% or amount realized- by transferee.28% of gain- by transferor.
      Exemptions Trade/business or net basis election. N/A If estimates paid under 1446, 28% W/H is N/A.
      Forms Needed for Exemption Form 4224 each year for each foreign partner. N/A N/A
      U.S Return Req. No Yes- Form 1040 NR . N/A
      Other Forms Needed Form 1042S with 4224.Forms W-8, 1001. Form 8813Form 8804 & Form 8805 Form 8288
      Due Dates 1042S- 3/15 8813- quarterly.8804- 4/15. 20 days after sale.
  • D. U.S. Taxation- Corporations
  • 1. Effectively Connected Income (EC)
    Income effectively connected (EC) with a U.S. trade/business (less deductions effectively connected) are taxable under U.S. corporate rates, up to 35%. Corporations, that own real estate, can also “elect” for such treatment. Gains from the sale of U.S. real property are deemed to be effectively connected.
  • There are special rules under the regulations for determining the interest expense that is effectively connected.
  • 2. Non-Effectively Connected (Fixed or Determinable Annual or Periodical Gains and Income– “FDAP” )
    Income received from sources in the U.S. that are not “effectively connected” are taxed at a flat 30% rate. This type of income is fixed or determinable annual or periodic income (FDAP) & includes the following:
  • Interest.
  • Dividends.
  • Rents.
  • Salaries, wages, compensations, renumerations.
  • Premiums & annuities.
  • FDAP income specifically does not include gains from the sale of property.
  • 3. Gains from the sale of U.S. Real Property (FIRPTA)
  • Dispositions of U.S. real estate by a foreign corporation are deemed to be effectively connected. Furthermore, transferees are required to withhold 10% of the sales proceeds. Foreign corporations can, however, to “elect” to be treated as domestic corporations, if it meets certain requirements under the regulations.
  • 4. Branch Profits Tax
  • Corporations that have effectively connected income have an additional tax equal to 30% of the “dividend equivalent amount” for the taxable year. This amount is reduced by treaty to 5%.
  • The “dividend equivalent amount” means the effectively connected earnings & profits for the taxable year adjusted as follows:
  • Reduced for increases (ending bal. current yr. less ending bal. prior year) in net equity (U.S. “effectively connected” assets less U.S. “effectively connected” liabilities).
  • Increased for decreases in net equity.
  • The policy behind this tax is to equate operating as a “branch” with operating as a “subsidiary”. Thus, the computation of the “dividend equivalent amount” starts with the earnings & profits and is increased by the decrease in net equity which are deemed to be dividends paid to the “parent”.
  • 5. Branch Level Interest Tax
  • A foreign corporation engaged in a U.S. trade or business is also potentially liable for this tax to the extent that the interest allowable under IRC Section 882 exceeds the actual amount paid.
  • 6. 5472 Filing Obligation
  • A foreign corporation must file form 5472 to report transactions with a related parties (25% direct/indirect owners or persons relate by 267(b) attribution rules).

 

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